There are several types of financial ratios that are applied to business. They contribute to the business’s financial health and are applied for different reasons and in various situations. Here is everything you need to know about financial ratios.
Liquidity ratios
Liquidity ratios measure the ability to pay off short–term obligations. In day–to–day operations, liquidity management is typically achieved through efficient use of assets. Common liquidity ratios include:
Current ratio
The current ratio expresses current assets concerning current liabilities. A higher ratio indicates a higher level of liquidity, and a lower ratio indicates less liquidity, implying a greater reliance on operating cash flow and outside financing to meet short–term obligations. The current ratio implicitly assumes that inventories and accounts receivable are indeed liquid.
Quick ratio or acid test ratio
The quick ratio is more conservative than the current ratio because it includes only the more liquid current assets. A higher quick ratio indicates greater liquidity and vice – versa. This ratio also reflects the fact that inventory might not be easily and quickly converted into cash.
Cash ratio
It is the most famous ratio to analyze the liquidity position of any company. The cash ratio normally represents a reliable measure of an entity’s liquidity in a crisis as only highly marketable short–term investments and cash are included.
Activity ratios
Activity ratios are also known as asset utilization ratios or operating efficiency ratios. Activity ratios are analyzed as indicators of ongoing operational performance – how effectively a company uses assets. It also reflects the efficient management of both working capital and longer-term assets. Since efficiency directly impacts liquidity, some activity ratios are also useful in assessing liquidity. The different types of activity ratios are given below:
Accounts receivable turnover
The accounts receivable turnover facilitates a comparison of the company sales and uncollected bills from customers. A relatively high receivables turnover ratio might indicate highly efficient credit and collection. Alternatively, a high receivables turnover ratio could indicate that the company’s credit or collection policies are too stringent, suggesting the possibility of sales being lost to competitors offering more lenient terms. A relatively low receivables turnover ratio would typically raise questions about the efficiency of the company’s credit and collections procedures.
Days of sales outstanding (DSO)
Days of sales outstanding represent the elapsed time between a sale and cash collection, reflecting how fast the company collects cash from customers to whom it offers credit. A lower number of days of sales outstanding are beneficial for the company and vice – versa.
Inventory turnover ratio
Inventory turnover ratio is also known as inventory turns ratio or stock turnover ratio. It indicates the resources tied up in inventory (i.e., the carrying costs) and indicates inventory management effectiveness. A lower inventory turnover ratio implies that inventory is held for a longer period which is harmful. In contrast, a higher inventory turnover ratio implies a shorter period than the inventory is held.
Days of inventory on hand (DOH)
Days of inventory on hand indicate the period inventory is held. A higher inventory turnover ratio a shorter period than the inventory is held, and thus a lower DOH and vice – versa.
Accounts payable turnover
The accounts payable turnover ratio is computed by account payable to sale. It measures the tendency of a company credit policy whether it extends account payable or not. The accounts payable turnover ratio measures how many times per year the company theoretically pays off all its creditors. If the ratio is high relative to the industry, it could indicate that the company is not making full use of available credit facilities; alternatively, it could result from a company taking advantage of early payment discounts. A meager turnover ratio could indicate trouble making payments on time or exploiting lenient supplier terms.
Accounts payable turnover in days
The accounts payable turnover in days reflects the average number of days the company pays its suppliers. A lower accounts payable turnover in days and high payables turnover ratio relative to the industry could indicate that the company is not making full use of available credit facilities.
A higher accounts payable turnover in days and lower accounts payables turnover ratio could indicate trouble making payments on time or exploiting lenient supplier terms. Suppose liquidity ratios indicate that the company has sufficient cash and other short–term assets to pay obligations, yet the day’s payable ratio is relatively high. In that case, it will favor the lenient supplier credit and collection policies as an explanation.
Fixed asset turnover ratio
This ratio measures how efficiently the company generates revenues from its investments in fixed assets. Generally, a higher fixed asset turnover ratio indicates a more efficient use of fixed assets in generating revenue. A low ratio can indicate inefficiency, a capital–intensive business environment, or a new business not yet operating at full capacity. Also, the fixed asset turnover ratio would be lower for a company whose assets are newer than the ratio for a company with older assets.
Total asset turnover ratio
The total asset turnover ratio measures the company’s overall ability to generate revenues with a given level of assets. A higher ratio indicates greater efficiency, and the lower ratio indicates the business’s inefficiency or relative capital intensity. Also, inefficient working capital management can distort overall interpretations.
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